Restaurant Law Blog

Crowdfunding is becoming an increasingly popular way for business owners to gain the financial backing they need to turn their concepts into realities. In recent years, websites like kickstarter.com have helped thousands of entrepreneurs obtain access to the funds they needed to get their projects off the ground. With the internet age upon us, the ability to reach people, and beg them for a few dollars, is easier than ever. However, would-be restaurateurs have not been as successful as other small business owners seeking financial backing in these arenas. Unlike other business owners, restaurant owners often need significant sums of money to open their doors. A donation of $10 in exchange for a coupon or a tee-shirt is not typically going to raise the amount of capital needed for a restaurant. But what if you, as a restaurant owner, could solicit true investors in exchange for a piece of your company?

Unfortunately for the hospitality industry, the regulations imposed by the New York State Liquor Authority (“NYSLA”), as codified in the Alcoholic Beverage Control Law (“ABC”), unintentionally limit the effectiveness and usefulness of crowdfunding. The recent approval by the SEC of new equity crowdfunding regulations, does not, unfortunately, relieve an owner from any statutory regulations or requirements pertaining its business. One such regulation is Section 111 of the ABC, which prohibits a licensed establishment, or principal thereof, from making its license available to a person who has not been approved by the NYSLA. Certain individuals are statutorily disqualified from holding a license, including those persons who: (a) are under the age of 21; (b) are not a U.S. citizen or alien admitted to the U.S. for permanent lawful residence; (c) have been convicted of any felony, or promoting or permitting prostitution, or the sale of liquor without an alcoholic beverage license; (d) are police officers or police officials; (e) have had an alcoholic beverage license revoked; or (f) presently hold a wholesale license. As a result of these limitations, there should be a clear process to eliminating these disqualified individuals from the target investment pool prior to launching a crowdfunding campaign.

Once funding has been procured, applicants, typically companies, are required to disclose the names, ages, citizenship and permanent home addresses for each and every one of its directors, officers and shareholders (or in the case of an LLC, its managing members and members) as part of the application process. However, if a company has more than 10 members or shareholders, then only those members or shareholders owning 10 percent or more of any class of stock or membership interest must be disclosed. This exception is unfortunately limited because applicants must still disclose all persons who “directly or indirectly have an economic interest in the applicant’s business by way of investment, loan or other financial arrangement.” In other words, any person who has given money to the applicant must be disclosed regardless of their ownership percentage.

For illustration purposes, assume that Tom is gifted a 5 percent membership interest in XYZ, LLC and that this LLC has 20 members. Under this scenario, assuming that Tom is not statutorily disqualified from holding a license, and further assuming that he is neither an officer nor managing member of the company, there is no requirement that his interest be disclosed. Likewise, in those limited circumstances where equity is not involved (such as in campaigns promoted on www.pieshell.com or www.inkind.com), crowdfunding can be a useful tool in raising small amounts of capital regardless of whether an alcoholic beverage license is sought. The flaw in this example is that people rarely are given a membership interest for no consideration. Instead, a more realistic example would be to assume that Tom acquired his membership interest by investing in the company or through some other financial transaction. Now, despite the fact that Tom owns less than 10% of the company, his interest must be disclosed because of his personal investment. It is this caveat - the equity investment - that complicates crowdfunding since it necessitates the disclosure of each participant, regardless of the size of his or her investment.

There are many appealing considerations when it comes to equity crowdfunding, particularly since many would-be restaurateurs do not have ample ‘connections’ to generate the investment needed to open an operate their business or because they may be unwilling to grant any single person, or group of individuals, a significant stake or voice in their business. Crowdfunding addresses these concerns by widely publicizing investment opportunities to a vast group of individuals, each of whom are given a chance to invest on a much smaller scale, and on terms generally considered more favorable for the company than your standard venture capital deal. One obvious downside, however, becomes the requirement of having to disclose hundreds of investors to the NYSLA.

So, how does an applicant disclose its investors? While the process is not overly complex, it is far from simple. The NYSLA requires that each investor complete a personal questionnaire detailing the following: name; date of birth; social security number; address; phone number; email address; citizenship; height; weight; hair color; eye color; sex; marital status; spouse name and social security number;, position in the company; percentage ownership; five-year residential history; five-year employment history; whether they will take an active part in the business; liquor license history and affiliations (New York State and beyond) to identify any interlocking interests; criminal history; and any applicable statutory disqualification. Additionally, each investor must provide proof of citizenship or alien status, a copy of their driver’s license or passport, a headshot photograph, submit to fingerprinting, and provide bank statements (typically 3 months) or other financial documentation showing the source of their investment. If the investment source is a personal bank account, then any deposit over $10,000 needs to be explained. A common scenario involves an individual who invests a sum of money (e.g. $15,000) and upon review of their bank records it is discovered that the source of his or her investment was a gift or transfer from a family member. In that situation the family member who gifted the funds would also need to complete a personal questionnaire and produce their bank records to show the source of the transferred funds.

Further complicating matters, if an investment source is a joint bank account (e.g. husband and wife), the non-investing spouse must also complete a personal questionnaire. As you might imagine, with potentially hundreds of investors, the disclosure process can become complex and onerous. The logistics of reviewing all of the required documents for each investor, as well as spouses, family members, etc., to ensure accuracy, compliance and an absence of tied house violations, can be cumbersome, particularly when you routinely have to communicate with each person to address identified deficiencies, ensure receipt of signed questionnaires, and confirm that everyone has been timely fingerprinted.

Personal questionnaires and accompanying applicant statements must then be signed by the investors and originals must be filed with the NYSLA as part of the company’s application. Once the application has been filed with the NYSLA, it will be reviewed and, where applicable, a deficiency letter will be issued to outline any aspect of the application that necessitates further documentation, support or clarity. Barring an extension, responses to a deficiency letter are required within 10 days from the date of the deficiency letter, meaning that an applicant may be required to address several investor deficiencies within a limited period of time. Language barriers, time zones, schedules (work, family, vacation) and other availability concerns pose real problems affecting an applicant’s ability to timely respond.

Assuming that an applicant is able to organize all its crowdfunding investors and coordinate the required filings, there remains a very real potential that one or more investors will, unwittingly, invest in more than one licensed business among the three tiers (e.g. bar and vineyard) in violation of tied-house restrictions. In such a scenario, regardless of the investor’s ultimate ownership (even if it were a nominal one), both businesses would be at risk of losing their license, or, if the businesses were still in the application stage, their application would likely be denied. At the present time, there are no online crowd-funding platforms that have a mechanism to identify and eliminate potential investors who hold an interlocking interest and ultimately the licensee bears the responsibility to insure that all crowd-sourced shareholders have properly disclosed their interests.

Even after the issuance of a license there are continuing disclosure obligations. The NYSLA requires license holders to apply for permission to make any corporate change involving: (1) and change of officers or directors, shareholders, members, etc.; (2) any change in ownership where there are fewer than 10 stockholders or LLC members; or (3) any change involving 10 percent or more of the ownership or any change which would increase a shareholder or LLC member’s ownership to 10 percent or more in companies where there are 10 or more stockholders or LLC members. Further, tied house restrictions are ongoing, so a licensed entity must be vigilant in educating its shareholders of the restrictions surrounding interlocking interests so that no after-the-fact investment is made in a business that might trigger a violation at some future point in time.

The new SEC rules on crowdfunding provide an intriguing opportunity for hospitality businesses to procure the illusive funding which is so often needed during their various stages of development and operation. This opportunity, while exciting, is not without risk or struggle, and attorneys counseling hospitality clients looking to source funding through an equity crowdfunding campaign should become knowledgeable of state and federal regulations which might otherwise complicate a simple capital raise.